The author reviews the underlying causes of the financial crises that have
occurred with increasing frequency in the past quarter century. He suggests
measures that countries can take to protect themselves from such crises and
argues that an international lender of last resort is neither necessary nor
sufficient to prevent future crises and, moreover, unlikely to be effective.
The recent financial crisis in East Asia has raised the question of whether current
international financial arrangements are adequate to protect the world from future
crises. During the past 25 years, financial crises have occurred with increasing
frequency, affecting 80–100 countries, with negative impacts on growth rates and
unemployment.
Economic theory and empirical research agree that capital market liberalization can
result in greater vulnerability to crisis. Opening a country's capital account
encourages short-term capital flows and increases potential instability. In East Asia,
huge short-term capital inflows after the opening of capital accounts were followed by
even more rapid outflows. Other forms of financial liberalization can lead to an
increase in risky lending by banks; in Thailand, investments in speculative real estate
grew dramatically after liberalization.
Stiglitz argues that reliance on prudential regulation is insufficient to safeguard
against increased risks of financial-sector liberalization, especially in countries with
poor information and limited transparency. In fact, relying on minimum capital adequacy
can reinforce instability: When the economy turns down and bankruptcies begin, banks
that fall below minimum capital requirements may curtail their lending, leading to
increases in nonperforming loans and bankruptcies.
Financial market liberalization may discourage economic growth because it is related to
increased instability, which goes far beyond the immediate actors—the borrowers
and lenders. The instability can affect people throughout the country and spread to
other countries. Because of these externalities, developing comprehensive programs of
institutional strengthening and interventions within countries is important.
Stiglitz outlines four areas for reform. First, government distortions that encourage,
even indirectly, short-term capital flows should be eliminated. For example, Thailand
directly facilitated short-term flows, and South Korea had restrictions on long-term
flows. Second, financial institutions need to be strengthened through improved
prudential regulations and supervision, greater transparency, and limitations on
lending. Third, direct interventions may be necessary to control financial flows outside
the banking system, such as the corporate borrowing that occurred in Indonesia.
These reforms may still be insufficient, as witnessed by recent financial crises in the
United States, Scandinavia, and Japan, so Stiglitz suggests that in some countries it
might also be prudent to impose additional limitations, such as limitations on lending
for investments in real estate, the use of derivatives by financial institutions, and
the rate at which overall lending can increase.
Lastly, Stiglitz argues for reforms in bankruptcy laws to distinguish between individual
company failure and systemic bankruptcy. For the latter, he recommends a “super
chapter 11,” in which existing company management would continue in place,
corporate reorganizations would be accelerated, and creditors' claims would be
rearranged. Reforms in bankruptcy along these lines would prevent the sort of downward
spiral that occurred in East Asia, where nonperforming loans grew, credit contracted,
and more companies became insolvent.
Regarding whether an international lender of last resort should be established, Stiglitz
raises a number of issues. First, a lender of last resort is not sufficient to protect
an economy from crisis; the Federal Reserve Bank in the United States was supposed to be
the lender of last resort, but it did not prevent the Great Depression. Second, for
countries with flexible exchange rates and adequate bankruptcy laws, a lender of last
resort is not necessary. Third, Stiglitz notes that automatic access to funds would
presumably be available only to countries that had acted in a reasonably prudent way.
But if a judgment were made that a country did not “qualify” for access to
funds, this judgment could signal that the country is a poor risk, which itself could
set off a crisis and which would defeat the purpose of having a lender of last resort.
Finally, Stiglitz doubts that countries would be willing to cede responsibility for
financial supervision to an international agency that is not politically accountable to
the country. Given the essential role that adequate supervision plays for a lender of
last resort, he concludes that an international agency would be unlikely to play this
role effectively.